Kevin Warsh is the new Fed Chair.
I find it hilarious that people are calling him a hawk based on what he did 10-15 years ago. This is like looking at old pics of me with a head full of hair (still have one of these on LinkedIn!). These times are long gone.
Jokes aside, I spent hours listening to the most recent interviews Warsh did (here and here, for example).
Here are the most consequential thoughts he shared:
1) is a choice, money creation drives it (as per Friedman, and that’s true in most cases);
2) Fed is backstop for banking system, but needs to get out when job is done (fair);
3) He believes inflationary money is created equally by Fed and the government (absolutely false: fiscal deficits create inflationary money, Fed monetary operations such as QE only create bank reserves);
4) He believes the Fed balance sheet being so big ‘’crowds out the private sector’‘ (absolutely false: the private sector uses another form of money i.e. bank deposits, there is no ‘’crowding out’’ of anything);
5) Need to get out of the ‘’fiscal and monetary’‘ mess inherited: a lot of talk about interest expense > defense spending (ok, so hear the plan now…);
6) ‘’If we ran the printing press a little quieter, we would have lower interest rates’’;
7) The plan is to shrink the Fed balance sheet, so we get lower rates, so the private sector can thrive = higher economic growth (he is looking at the wrong printing press – Bessent has the key one, not the Fed);
8) Rates should also be lower because we are on the verge of a productivity boom (his opinion, fair enough);
9) The Fed should not be data dependent; data is revised all the time, so why be? Best to have an opinion and stick to it. Also, the Fed should not share economic forecasts, no dots. No forward guidance (uncertainty up).
It’s pretty clear, Warsh – as many others, by the way – gets money creation wrong. But it still leads to some key consequences for markets:
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Shrinking the balance sheet and following the AI productivity fairytale will be two convenient covers Warsh will use to push for cutting Fed Funds further.
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front-end rates further will help the remain weak;
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Injecting instability in the repo market through a reduction of the balance sheet, cutting front-end rates proactively, and slashing forward guidance tools = uncertainty up = steeper curves.
One key thing to consider is that if Warsh manages to shrink the Fed balance sheet, this could have an impact on the repo market.
The chart below shows how bank reserves as % of total US nominal have been shrinking and approaching the potentially dangerous 8-9% level – last time it breached that, we had a repo blowup in 2019.
This is because bank reserves are very unevenly distributed across US banks, and once they start becoming scarce, the odds of interbank liquidity drying up for smaller banks increase:
Do you know who put forward this ratio, by the way?
Waller! (Read his speech here).
Shrinking the balance sheet further here would put the stability of the repo market at risk, and by the way, in December 2025, the Fed resumed purchases of T-Bills with the very intent to avoid such risks (here).
The odds of Warsh convincing his colleagues to shrink the balance sheet further here are low.
But now let’s assume that Warsh still manages to put through his lower balance sheet + AI productivity fairytale to convince his colleagues to cut rates a bit faster. And that forward guidance disappears.
Then the US yield curve would steepen, and that goes against what the US administration wants:
Wait, why am I showing you a chart of against yields for Japanese investors?
Because this is a key chart for Bessent to push in the right direction, as it would achieve a great deal of positive outcomes for the US administration.
For years, Japanese investors have bought foreign bonds WITHOUT hedging the FX risk at all – and why?
Because the assumption was that the was going to get weaker, and hence Japanese investors could:
1) Get a higher yield in foreign bond markets;
2) Benefit from the JPY weakness on top.
And it’s in the clear interest of the US administration to reverse this mechanism.
Getting Japanese investors to buy more JGBs would encourage repatriation of capital and help JPY appreciate, plus support the Japanese bond market and help global long-end bond yields stabilize.
Very soon, it might be that Japanese investors wouldn’t really have any advantage in buying 30-year US Treasuries (after FX hedging costs) rather than keeping money in Japanese bonds.
A steeper US curve would bring Japanese investors back into their old habits, and that’s not what the US wants.
So, here we are trying to solve the puzzle.
We have Warsh likely using Fed balance sheet reductions and the AI productivity story to cut rates.
Unlikely to really succeed, but the bias will be for a dovish Fed (what a surprise!).
That helps the USD to weaken and equities to go up (two clear US admin objectives), but Warsh is a curve steepener – and if long-end bonds get out of hand, Bessent and Japan could be ready to intervene.
Bessent can tweak issuance further to the front-end, and Japan can backstop its own long-end bonds too.
This leaves us in a scenario where, in the medium term:
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We keep running the global economies hot via major fiscal spending programs worldwide;
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The Fed maintains a dovish inclination;
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Bond yields are flat or down;
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The USD trades flat or down;
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Commodities and equities maintain the most upside convexity
I believe the asset classes poised to deliver the best risk-adjusted returns over the next 3-6 months are:
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International, value-oriented stock markets (e.g. Europe, Japan, Canada, specific Emerging Markets);
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Precious metals and industrial commodities (e.g. Copper).
This was it for today. Thanks for reading.
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